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MEASURING GDP Objectives

AND ECONOMIC CHAPTER

GROWTH After studying this chapter, you will able to

ƒ Define GDP and use the circular flow model to explain
why GDP equals aggregate expenditure and aggregate
income
ƒ Explain the two ways of measuring GDP
ƒ Explain how we measure real GDP and the GDP deflator
ƒ Explain how we use real GDP to measure economic
growth and describe the limitations of our measure

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An Economic Barometer Gross Domestic Product

GDP Defined
What exactly is GDP GDP or gross domestic product, is the market value of
How do we use it to tell us whether our economy is in a all final goods and services produced in a country in a
recession or how rapidly our economy is expanding? given time period.
How do we take the effects of inflation out of GDP to This definition has four parts:
compare economic well-being over time
ƒ Market value
And how to we compare economic well-being across
ƒ Final goods and services
counties?
ƒ Produced within a country
ƒ In a given time period
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Gross Domestic Product Gross Domestic Product

Final goods and services

Market value
GDP is a market value—goods and services are valued at
their market prices.
To add apples and oranges, computers and popcorn, we
add the market values so we have a total value of output
in dollars.
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GDP is the value of the final goods and services
produced.
A final good (or service), is an item bought by its final
user during a specified time period.
A final good contrasts with an intermediate good, which is
an item that is produced by one firm, bought by another
firm, and used as a component of a final good or service.
Excluding intermediate goods and services avoids double
counting.
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Gross Domestic Product
Produced within a country
GDP measures production within a country—domestic
production.
In a given time period
GDP measures production during a specific time period,
normally a year or a quarter of a year.
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Gross Domestic Product
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Gross Domestic Product
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Gross Domestic Product
GDP and the Circular Flow of Expenditure and Income
GDP measures the value of production, which also equals
total expenditure on final goods and total income.
The equality of income and output shows the link between
productivity and living standards.
The circular flow diagram in Figure 20.1 illustrates the
equality of income, expenditure, and the value of
production.
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Gross Domestic Product
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Gross Domestic Product
The circular flow diagram shows the transactions among
households, firms, governments, and the rest of the world
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Gross Domestic Product Gross Domestic Product

These transactions take place in factor markets, goods Firms hire factors of production from households. The blue
markets, and financial markets. flow, Y, shows total income paid by firms to households.

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Gross Domestic Product Gross Domestic Product

Households buy consumer goods and services. The red Households save, S, and pay taxes, T. Firms borrow some
flow, C, shows consumption expenditures. of what households save to finance their investment.

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Gross Domestic Product Gross Domestic Product

Firms buy capital goods from other firms. The red flow I Governments buy goods and services, G, and borrow or
represents this investment expenditure by firms. repay debt if spending exceeds or is less than taxes

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 Gross Domestic Product Gross Domestic Product

The rest of the world buys goods and services from us, X And the rest of the world borrows from us or lends to us
and sells us goods and services, M—net exports are X - M depending on whether net exports are positive or negative.

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Gross Domestic Product Gross Domestic Product

The blue and red flows are the circular flow of income and The sum of the red flows equals the blue flow.
expenditure. The green flows are borrowing, lending, and taxes.

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Gross Domestic Product Gross Domestic Product

That is: Y = C + I + G + X - M
The circular flow demonstrates how GDP can be
measured in two ways.
Aggregate expenditure
Total expenditure on final goods and services, equals the
value of output of final goods and services, which is GDP.
Total expenditure = C + I + G + (X – M).

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Gross Domestic Product Gross Domestic Product

Aggregate income Financial Flows

Aggregate income earned from production of final goods,
Y, equals the total paid out for the use of resources,
wages, interest, rent, and profit.
Firms pay out all their receipts from the sale of final goods,
so income equals expenditure,
Y = C + I + G + (X – M).
Financial markets finance deficits and investment.
Household saving S is income minus net taxes and
consumption expenditure, and flows to the financial
markets;
Y = C + S + T,
income equals the uses of income.

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Gross Domestic Product Gross Domestic Product

How Investment Is Financed

If government purchases exceed net taxes, the deficit
(G – T) is borrowed from the financial markets (if T
exceeds G, the government surplus flows to the markets).
If imports exceed exports, the deficit with the rest of the
world (M – X) is borrowing from the rest of the world.
Investment is financed from three sources:
ƒ Private saving, S
ƒ Government budget surplus, (T – G)
ƒ Borrowing from the rest of the world (M – X).

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Gross Domestic Product Gross Domestic Product

We can see these three sources of investment finance by

using the fact that aggregate expenditure equals Gross and Net Domestic Product
aggregate income. “Gross” means before accounting for the depreciation of
Start with capital. The opposite of gross is net.

Y = C + S + T = C + I + G + (X – M). To understand this distinction, we need to distinguish

between flows and stocks in macroeconomics.
Then rearrange to obtain
A flow is a quantity per unit of time; a stock is the quantity
I = S + (T – G) + (M – X) that exists at a point in time.
Private saving S plus government saving (T – G) is called
national saving.

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Gross Domestic Product Gross Domestic Product

Wealth, the value of all the things that people own, is a

stock. Saving is the flow that changes the stock of wealth.
Gross investment is the total amount spent on purchases
Capital, the plant, equipment, and inventories of raw and of new capital and on replacing depreciated capital.
semi-finished materials that are used to produce other
goods and services is a stock. Net investment is the change in the stock of capital and
equals gross investment minus depreciation.
Investment is the flow that changes the stock of capital.
Depreciation is the decrease in the capital stock that
results from wear and tear, and obsolescence.
Capital consumption is another name for depreciation.

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Gross Domestic Product

Figure 20.2 illustrates the

relationships among
capital, gross investment,
depreciation, and net
investment.

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Gross Domestic Product Measuring Canadian GDP

Gross profits, and GDP, include depreciation.

Similarly, gross investment includes that amount of
Statistics Canada uses two approaches to measure GDP
purchases of new capital goods that replace depreciation
ƒ The expenditure approach
Net profits, net domestic product, and net investment
subtract depreciation from the gross concepts. ƒ The income approach
Investment plays a central role in the economy. Increases
in capital are one source of growth in potential real GDP;
fluctuations in investment are one source of fluctuations in
real GDP.

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Measuring Canadian GDP Measuring Canadian GDP

The Expenditure Approach

The expenditure approach measures GDP as the sum of
consumption expenditure, investment, government
purchases of goods and services, and net exports.
Table 20.1 in the textbook shows the expenditure
approach with data for 2001.
The Income Approach
The income approach measures GDP by summing the
incomes that firms pay households for the factors of
production they hire.

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Measuring Canadian GDP Measuring Canadian GDP

The National Income and Expenditure Accounts divide

incomes into five categories Two adjustments must be made to get GDP

1. Wages, salaries, and supplementary labour income
2. Corporate profits
3. Interest and miscellaneous investment income
4. Farmers’ income
5. Income from non-farm unincorporated businesses
ƒ Indirect taxes minus subsidies are added to get from
factor cost to market prices.
ƒ Depreciation (or capital consumption) is added to get
from net domestic product to gross domestic product.
Table 20.2 in the textbook shows the income approach
with data for 2001.

The sum of these five income components is net domestic

income at factor cost.
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Real GDP and the Price Level Real GDP and the Price Level

Item Quantity Price

Real GDP is the value of final goods and services The table provides data for
produced in a given year when valued at constant prices. 2002 and 2003. 2002

Calculating Real GDP In 2002, nominal GDP is: Balls 100 $1.00

The first step in calculating real GDP is to calculate Expenditure on balls $100 Bats 20 $5.00
nominal GDP, which is the value of goods and services
produced during a given year valued at the prices that Expenditure on bats $100 2003
prevailed in that same year. Nominal GDP $200
Balls 160 $0.50

Bats 22 $22.50

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Real GDP and the Price Level Real GDP and the Price Level

Item Quantity Price Item Quantity Price

The old method of
2002 calculating real GDP was 2002
In 2003, nominal GDP is:
Balls 100 $1.00 to value each year’s output Balls 100 $1.00
Expenditure on balls $80 at the prices of a base
Bats 20 $5.00 year—the base year prices Bats 20 $5.00
Expenditure on bats $495
method.
Nominal GDP $575 2003 2003
Suppose 2002 is the base
Balls 160 $0.50
year and 2003 is the Balls 160 $0.50
current year.
Bats 22 $22.50 Bats 22 $22.50

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Real GDP and the Price Level Real GDP and the Price Level

Item Quantity Price

Expenditure on balls in
2003 valued at 2002 prices 2002 The new method of calculating real GDP, which is called
is $160. the chain-weighted output index method, uses the
Balls 100 $1.00
prices of two adjacent years to calculate the real GDP
Expenditure on bats in
2003 valued at 2002 prices Bats 20 $5.00 growth rate.
is $110. This calculation has four steps described on the next slide.
2003
Real GDP in 2003 (base-
year prices method) is Balls 160 $0.50
$270.
Bats 22 $22.50

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Real GDP and the Price Level Real GDP and the Price Level

Step 1: Value last year’s production and this year’s

production at last year’s prices and then calculate the Item Quantity Price
growth rate of this number from last year to this year. We’ve done step 1.
2002
Step 2: Value last year’s production and this year’s 2002 production at 2002
production at this year’s prices and then calculate the prices (GDP in 2002) is Balls 100 $1.00
growth rate of this number from last year to this year. $200.
Bats 20 $5.00
Step 3: Calculate the average of the two growth rates. 2003 production at 2002
prices is $270. 2003
This average growth rate is the growth rate of real GDP
from last year to this year. The 2003 growth rate in
Balls 160 $0.50
2002 prices is 35 percent.
Step 4: Repeat steps 1, 2, and 3 for each pair of adjacent
Bats 22 $22.50
years to link real GDP back to the base year’s prices.
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Real GDP and the Price Level Real GDP and the Price Level

Item Quantity Price Step 3. Item Quantity Price

Step 2.
2002 The 2003 growth rate in 2002
2002 production at 2003 2002 prices is 35 percent.
prices is $500. Balls 100 $1.00 Balls 100 $1.00
The 2003 growth rate in
2003 production at 2003 2003 prices is 15 percent.
Bats 20 $5.00 Bats 20 $5.00
prices (GDP in 2003) is The average of these two
$575. 2003 growth rates is 25 percent. 2003
The 2003 growth rate in Real GDP in 2003 with
2003 prices is 15 percent. Balls 160 $0.50 2002 as the base year is Balls 160 $0.50
$250.
Bats 22 $22.50 Bats 22 $22.50

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Real GDP and the Price Level Real GDP and the Price Level

Item Quantity Price Calculating the Price Level

Step 4. 2002 The average level of prices is called the price level.
Because we’re calculating Balls 100 $1.00 One measure of the price level is the GDP deflator, which
real GDP in 2003 at 2002 is an average of the prices of the goods in GDP in the
prices, step 4 is completed! Bats 20 $5.00 current year expressed as a percentage of the base year
Real GDP in 2002 is $200 prices.
2003
Real GDP in 2003 is $250 The GDP deflator is calculated in the table on the next
Balls 160 $0.50 slide (and in Table 20.7 in the textbook).
Bats 22 $22.50

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Real GDP and the Price Level Real GDP and the Price Level
Deflating the GDP Balloon
Nominal GDP and real GDP are calculated in the way
Nominal GDP increases because production—real GDP–
that you’ve just seen. increases.
GDP Deflator = (Nominal GDP/Real GDP) × 100.
In 2002, the GDP deflator is ($200/$200) × 100 = 100.
In 2003, the GDP deflator is ($575/$250) × 100 = 230.

Year Nominal Real GDP

GDP GDP deflator
2002 $200 $200 100

2003 $575 $250 230

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Real GDP and the Price Level
Nominal GDP also increases because prices rise.
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Measuring Economic Growth
We use real GDP to calculate the economic growth rate.
The economic growth rate is the percentage change in
the quantity of goods and services produced from one
year to the next.
We measure economic growth so we can make:
ƒ Economic welfare comparisons
ƒ International welfare comparisons
ƒ Business cycle forecasts
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Measuring Economic Growth
Economic Welfare Comparisons
Economic welfare measures the nation’s overall state of
economic well-being.
Real GDP is not a perfect measure of economic welfare
for seven reasons:
3. Real GDP, as measured, omits the underground
economy, which is illegal economic activity or legal
economic activity that goes unreported for tax avoidance
reasons.
4. Health and life expectancy are not directly included in
real GDP.
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Real GDP and the Price Level
We use the GDP deflator to let the air out of the nominal
GDP balloon and reveal real GDP.
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Measuring Economic Growth
Economic Welfare Comparisons
Economic welfare measures the nation’s overall state of
economic well-being.
Real GDP is not a perfect measure of economic welfare for
seven reasons:
1. Quality improvements tend to be neglected in calculating
real GDP so the inflation rate is overstated and real GDP
understated.
2. Real GDP does not include household production, that
is, productive activities done in and around the house by
members of the household.
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Measuring Economic Growth
Economic Welfare Comparisons
Economic welfare measures the nation’s overall state of
economic well-being.
Real GDP is not a perfect measure of economic welfare
for seven reasons:
5. Leisure time, a valuable component of an individual’s
welfare, is not included in real GDP.
6. Environmental damage is not deducted from real GDP.
7. Political freedom and social justice are not included in
real GDP.
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Measuring Economic Growth Measuring Economic Growth

International Comparisons
Real GDP is used to compare economic welfare in one
country with that in another.
Two special problems arise in making these comparisons.
Real GDP of one country must be converted into the same
currency units as the real GDP of the other country, so an
exchange rate must be used.
The same prices should be used to value the goods and
services in the countries being compared, but often are
not.
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Using the exchange rate to compare GDP in one country
with GDP in another country is problematic because prices
of particular products in one country may be much less or
much more than in the other country.
Using the exchange rate to value Chinese GDP in dollars
leads to an estimate that U.S. real GDP per person was 69
times Chinese real GDP per person.
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Measuring Economic Growth

Using purchasing
power parity prices
leads to an estimate
that per person GDP
in the United States is
(only) 12 times that in
China—see Figure
20.4.

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Measuring Economic Growth MEASURING GDP
AND ECONOMIC CHAPTER

GROWTH
Business Cycle Forecasts
Real GDP is used to measure business cycle fluctuations.
These fluctuations are probably accurately timed but the
changes in real GDP probably overstate the changes in
total production and people’s welfare caused by business
cycles. THE
END
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